2011 • Volume 36 • Number 1

What is ‘financial innovation,” and why should we care about it? This question has become increasingly important in the wake of the recent financial crisis, yet the nature of financial innovation remains poorly understood. Drawing on the “New Institutional Economics” literature, this article contends that financial innovation should be understood first and foremost as a process of change, a change in the type and variety of available financial products to be sure, but also a change in financial intermediaries (such as banks) and in markets, themselves. It argues that this reframing has important policy implications for the economics of regulating the financial innovation process and for understanding the dynamics of modern financial markets in general. As an illustration of these ideas, this article undertakes a critical analysis of a rule that would require banks that deal in over-the-counter derivatives to transfer the management of certain risks associated with these instruments to a highly regulated third party called a centralized clearing party. This rule has been proposed in Europe and was recently adopted in the United States by the Dodd-Frank Wall Street Reform and Consumer Protection Act. This article argues that this rule is properly viewed as an attempt to regulate the process of financial innovation itself and that, when viewed in this light, the rule is neither as modest nor as obviously superior to the status quo as its adherents claim. Finally, this article sketches two alternatives to this rule that seek to navigate the trade-offs of what the article refers to as the “new” economics of financial regulation.